Winter 2015

Tag Archives: crude oil

Thesis: With the recent drop in crude oil prices, smaller U.S. shale companies are going to start being acquired at a rapid clip by larger rivals.

Crude oil prices dropped form over $100 a barrel to the low $40’s per barrel and are now hovering around $48 a barrel. The reason why prices were able to drop so severely is because the United States (a typically heavy importer of oil) experienced a boom in shale by a process known as hydraulic fracturing. These reserves added to the global supplies resulting in an oversupply of crude oil causing the price to drop. Furthermore, OPEC (the largest oil producing organization in the world) decided not to cut oil production in the region (which was the typical policy in order to keep prices elevated). Now you may be wondering why OPEC would do such a move. Many producers in that region can drill and get oil out of the ground around $10 a barrel, so even at $48 a barrel they are profitable. Now the U.S. shale companies have a much higher cost of drilling and getting oil out of the ground. The most efficient can manage $40 a barrel, but the norm is closer to $50 a barrel, and many can’t even produce at those levels according to an article published by CNBC.

Many small U.S. companies set out on oil exploration projects and used leverage (or debt) to finance the projects. But now, the price of crude oil is below their drilling costs to get it out of the ground. So they are highly leveraged, not capable of making net profits, and are unable to attain financing to grow. So why would anyone want to acquire one of these companies? The answer: their oil reserves and land. Large oil giants such as Exxon Mobil XOM or Chevron CVX are able to purchase these smaller, struggling companies at an incredible discount right now. They have the capital and pipelines to continue operations and can boost their oil reserves by purchasing these smaller companies. A Bloomberg article titled “Get Ready for Oil Deals: Shale is Going on Sale” mentions some of the top buyout targets. The reason why now is the time for deals to start occurring is because crude oil has been below $60 a barrel for all of 2015 and prices below $50 a barrel for half of that time frame. So these smaller companies have experienced an entire quarter of producing at losses with no medium term catalysts for crude prices to rally in sight. The main tradeoff is that the smaller companies get to avoid bankruptcy or further share price decline while the larger companies who can tolerate the losses in the short term receive a big discount in acquiring oil reserves.

Few weeks ago I wrote about how the price of crude oil may rebound sharply. It’s looking more and more likely that I was wrong. While oil prices will still rebound, it will be a slow one.

As I have stated in an earlier post, the current state of low oil prices is caused by a combination of falling demand from China and India, OPEC refusing to cut production, and increased U.S. production. And since the price drop, many shale drillers in the U.S. have cut production. With those in mind, plus the fact that in 2009 oil prices rebounded sharply, I believed that the same would happen again.

What I forgot to address the high amounts of oil currently in storage. With oil prices in record lows, many investors are jumping onto the oil storage game. According to an article on Reuters, traders are now purchasing oil for storage. The amount of activity in this sector have kept the price of oil futures low, no more than $60 per barrel in fact.

Data on oil futures, taken from barchart.com (As of Feburary 11, 2015)

The chart above shows that futures on crude oil is being traded at as low as $63.68 per barrel, even for January 2017. That means buyers can secure crude for this price to be delivered in January 2017. This also means that traders can purchase oil at the current price of below $50 per barrel, and immediately sell a futures contract for some $60 per barrel. For those who can secure storage facilities or tankers, they can make a lot of money. But of course, this would attract more investors, which should drive up current oil prices while driving down future oil prices.

But what is interesting is that the current price of oil remained low. In fact, oil prices have dropped yet again in the past few days. (Wall Street Journal) This is because the supply of oil in the U.S. has not been cut as we were led to believe. According to the U.S. Energy Information Administration, the daily production of crude oil in the U.S. is currently at 9.2 million barrels, a number not seen since 1973. (1973 was shortly after the production of oil in the U.S. peaked) I will venture to guess that shale drillers claimed to be cutting production hoped to rouse speculators into buying more oil, thus driving up the price. But since oil drilling requires huge amounts of sunk costs, especially true for drilling in shale, these companies are reluctant to cut production after investing so much.

So as it currently is, the glut of oil will continue to grow, at least until existing oil wells are depleted. But even then, we will have huge amounts in storage. Such that the price of oil will remain low for the foreseeable future.

This has been the most interesting year for oil for as long as I can remember. Talking with my parents, they say it’s hard to believe the incredible supple of oil available at this moment. When they were growing up, there was a quota on how much gas someone could get in a week. Now, the supple is so high prices are down to levels not seen in decades. Oil prices are now at a one month high after prices shot up 7% on Tuesday. Oil futures continue to rise, with Tuesday marking the fourth straight day of prices increases. This marks the longest winning streak for oil in six months. According to the article, “Tuesday’s rally came in response to a U.S. refinery strike, which pushed up prices for petroleum products on concerns that the refineries could shut down fuel production.” http://www.wsj.com/articles/oil-extends-rally-but-markets-cautious-over-rebound-1422944186. If fuel productions fell, this would lessen the supply of oil, leading to a surge in prices. While oil prices have been showing signs of recovering, I do not think we have seen the end to low prices. If one oil refinery decides to cut production, they could be undercut by one of their competitors. There needs to be some sort of assurance that all oil producers agree to cut production. I believe this may happen, but it will not lead to prices going back up to $100 dollars a barrel. I believe prices will increase, but gradually find a steady state well below this summers levels. While US oil producers want to cut production, there is still an over supply on the global level. This will not get solved easily it is nearly impossible to get all oil producing companies around the world to cut production and spending in 2015. Many oil producing companies are losing money and will cut spending in 2015. This will lead to layoffs and lessened production. It will be interesting to see how companies that have oil and a main factor of production react. Oil futures continue to rise, indicating companies are playing it safe. by buying at prices they believe will continue to rise. According to marketwatch, “Crude-oil futures rallied well above $50 a barrel to settle at their highest levels of 2015 Tuesday, as prices jumped on speculation that a sharp decline in U.S. drilling activity will result in supply declines.” http://www.marketwatch.com/story/oil-prices-continue-to-rise-as-investors-worry-about-supply-cuts-2015-02-03. This article also notes that they do not believe this decline in drilling will be enough to offset the global oversupply. On a worldwide scale, there is a surplus of 1.5 million barrels per day. This is remarkable and explains why prices are so low. It will be interesting to see if companies on a global scale follow the US’s lead and cut down on drilling and production in order to raise prices. With many economics struggling worldwide, I find it doubtful this will happen anytime soon. It will be interesting to see how it all plays out!

Crude oil has fallen from over $100 a barrel this summer to closing below $46 a barrel. Such a low closing price represents a low not seen in over five and a half years according to an article published by CNBC. There are many factors that have contributed to such a sharp decline in oil prices. First of all, basic supply and demand dictates that an oversupply of any given good leads to a decline in prices. United States shale production has contributed to this oversupply of oil. In recent years, hydraulic fracturing, which is more commonly known as fracking, has been a controversial topic. On one spectrum, fracking enables United States oil producers to produce oil using the nation’s own natural resources. The opposing side argues that fracking has negative implications for the environment including pollution of water and the ozone. Although there has been much controversy and political debate, fracking continues in America.

In a controversial decision made a couple months ago, the largest oil producing region OPEC announced that it would not be cutting oil production. In the past, whenever there was an oversupply of oil in the global economy, OPEC would step in and slash production to ensure price stability. However, this time OPEC stated that they would not intervene in an attempt to force higher cost producers out of the market. Many producers in Saudi Arabia can remain profitable with oil as low as $10 a barrel. Most fracking corporations can only remain profitable around $40-$50 a barrel. Surely, many of the higher cost producers are already feeling pressure and are scaling back production.

Canadian oil producers are marching to a different beat, especially in the oil-sands region. “On Monday, major producer Canadian Natural Resources Ltd. became the latest to underscore the resilience of oil-sands growth. The company said lower oil prices will force it to trim investment on new projects and curtail its growth forecast – but it still expects output to grow 7% over 2014 levels, and it vowed to keep spending on expanding output at its biggest oil-sands mine over the next two years (Dawson). The preceding quote was taken from a Wall Street Journal article outlining how Canadian producers are taking a long term approach even as oil dips below $50 a barrel. The article goes on to state that many of the projects in the oil-sands region have 30 year production cycles. Furthermore, most of the projects have large upfront costs that benefit from scale. Lastly, producers in the oil-sands region can remain profitable even if oil were to slide between $25-35 a barrel.

Parting thoughts: the move by many Canadian oil producers to continue investing in oil projects despite a shocking drop in prices may be alarming at first, but makes sense according to the numbers. There are higher cost methods of producing oil including fracking and deep shore drilling that will be cut prior to Canada’s relative low cost of production. If oil prices stay depressed for an extended period of time or slide even further, the lowest cost producers will be the winner’s and the companies with the high production costs will be forced out of business.

If you have been paying attention to the news lately, or even if you haven’t, you have probably heard about plummeting oil prices worldwide. Crude oil, which reached $100 a barrel less than a year ago, has now dropped as low as roughly $45 a barrel (The Wall Street Journal, Market Data Center). Everyday Americans view this as a great thing. I mean who doesn’t like cheap gasoline at the pump. For countries whose economy largely depends on exporting oil, however, this is a very bad thing.

One nation that has been hit extremely hard by falling oil prices is Russia.

“Heavily dependent on oil exports that are priced in U.S. dollars, Russia faces mounting pressure from U.S. and European officials over the unrest in eastern Ukraine. On Saturday, U.S. and European leaders threatened new sanctions against Moscow” (Albanese, Armental, 2015).

Russia is learning that their economy may have one huge fatal flaw, if they already didn’t know. Depending too heavily on one single commodity, crude oil, opens up their economy to extreme volatility. If the value of crude oil falls significantly, which is happening currently primarily due to increased global supply, the value of their entire economy also falls significantly. This openness to extreme volatility is exactly what is crippling the Russian economy currently. This is reflected by the falling price of the Ruble, Russia’s currency. However, this is just one of the issues that Russia is facing.

“The ruble, which has been in a free fall amid slumping oil prices and geopolitical unrest in the region, was trading at about 68 rubles to the dollar Monday, compared with about 35 rubles a year ago” (Albanese, Armental, 2015).

This “geopolitical unrest” that the above quotation is referring to is the conflict in Ukraine that has been going on for some time now.

“A surge in fighting in eastern Ukraine, which killed about 30 civilians in the Kiev-controlled town of Mariupol over the weekend, prompted U.S. and European leaders to threaten new sanctions against Moscow” (Albanese, Ostroukh, Armental, 2015).

“The sanctions, which cut off Russian banks and companies from global capital markets, are widely expected to push the commodity-dependent economy into contraction for the first time since 2009” (Albanese, Ostroukh, Armental, 2015).

If the falling global price of crude oil is not enough to sink the oil dependent Russian economy, facing sanctions and being cut off from global markets should just about do it. Changes need to be made, if Russia wants to remain a global player long term. Now don’t get me wrong, Russia is still one of the world’s most powerful nations that cannot be ignored. However, it seems that all of Russia would benefit, if Putin and Medvedev took a step back and reevaluated their cold-war-esque foreign policy, and drastically restructured their economy to keep up with the changing times. No more, it seems, that a nation can rely on natural resources alone to create a prosperous economy. No more are the days that a nation can invade another nation, and not expect serious backlash from the global community.